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Foreign trusts routinely cause U.S. reporting headaches for taxpayers. Generally, tax professionals must grapple with both the language used in the trust and applicable foreign law to determine the proper characterization of the trust for federal tax purposes. In addition, foreign trusts usually require complex information reporting, such as IRS Form 3520 and 3520-A.
A recently filed complaint in Geiger v. U.S. (S.D. Fla.) illustrates the difficulties and complexities of foreign trust reporting. In that case, the personal representative of an estate contends that the IRS improperly characterized a Liechtenstein foundation—referred to as World Capital Foundation (WCF)—as a foreign grantor trust rather than a foreign non-grantor trust. According to the complaint, the distinction is worth approximately $15 million.
Background
In 1982, a German national, Eugen, created WCF. Roughly seven years later, Eugen passed away, leaving the beneficial interests of the trust to his son, Gunter.
In 2010, Gunter surrendered his U.S. green card and moved to Europe. According to the complaint, Gunter never made contributions to WCF and never had decision-making authority over the trust until after he expatriated.
In 2012, Gunter sought protection under the now-defunct Offshore Voluntary Disclosure Program (OVDP). Under that program, taxpayers could disclose unreported foreign assets and income by submitting eight years of amended and corrected returns. In exchange, the IRS offered more leniency on penalties and reduced risks of criminal prosecution. In his OVDP submission, Gunter filed amended returns for 2003 through 2010 and Forms 3520 and 3520-A, claiming that WCF was a foreign grantor trust.
However, after the submission but prior to entering into a closing agreement, Gunter changed course and argued that WCF was a foreign non-grantor trust. Based on allegations in the complaint, Gunter made this decision after consulting with WCF’s trustees, an attorney in Liechtenstein, and his own tax advisors.
On February 5, 2015, Gunter passed away, and his son, Grant, began to serve as the estate’s personal representative. According to the complaint, the IRS had initially agreed that WCF was a foreign non-grantor trust. Nevertheless, the IRS did not stick with this determination, concluding instead that WCF was a foreign grantor trust. Because Grant and the IRS could not agree on the characterization of WCF, the IRS pulled the estate out of the OVDP for a “lack of cooperation.” Making matters worse, the agency further sought jeopardy assessments against the estate and heirs, which would allow the IRS to assess and collect the taxes and penalties more quickly. In response, Grant filed a complaint with the federal district court, seeking to stop the jeopardy assessment determinations.
Grantor Versus Non-Grantor Trusts
In its complaint, the estate contends that the jeopardy assessments are not reasonable or appropriate because WCF was a foreign non-grantor trust for federal income tax purposes. To better understand the arguments raised by the estate in Geiger, it is crucial to also understand the differences between grantor and non-grantor trusts.
Grantor and non-grantor trusts are treated differently for federal income tax purposes. Grantor trusts are disregarded—conversely, non-grantor trusts are respected as separate and distinct taxable entities. Because grantor trusts are disregarded, the assets of the trusts are attributed to the grantor. In fact, federal tax law treats the grantor as directly owning the trust’s assets, requiring the grantor to report the trust’s income and other activities on the grantor’s tax return. By comparison, non-grantor trusts generally file their own tax returns and pay their own taxes (assuming they are subject to U.S. tax), unless the trust makes a taxable distribution to a beneficiary.
Trusts qualify as grantor trusts if they meet one or more requirements under the grantor trust rules, which are located in sections 671 through 679 of the Code. Generally, these rules apply if the grantor transfers property to trust and retains certain rights to the trust’s income or principal or the right to control and direct the trust’s income or principal. The grantor trust rules can also apply to foreign trusts if a U.S. person transfers property to the trust and it has one or more U.S. beneficiaries.
The Importance of Non-Grantor Status in Geiger
In Geiger, the complaint contends that WCF was not a grantor trust because Gunter never: (i) transferred funds to the trust; and (ii) had sufficient control over the trust’s income or principal until after he expatriated. Given the IRS’ apparent position administratively, the government will likely file an answer that disagrees with the allegations raised in the complaint.
If the court reaches the merits of the proper characterization of WCF and sides with the IRS, there would be several adverse tax consequences to the estate (all of which presumably support the jeopardy assessment determination). First, Gunter would be treated as the owner of the trust’s assets for federal income tax purposes. Accordingly, Gunter would have been responsible for reporting and paying taxes on income WCF earned each tax year. To the extent such income was not properly reported, the IRS could argue that the estate should be liable for the unpaid income taxes, applicable penalties, and interest associated with the improper reporting.
Second, Gunter would have had Form 3520 and 3520-A filing obligations. If Gunter failed to timely file these information returns, the estate could be liable for civil penalties. For example, the IRS could argue that it properly assessed Form 3520-A late-filing penalties equal to 5% of WCF’s trust principal, as valued at the end of each applicable tax year.
Third, Gunter would have been subject to a higher “exit tax” under section 877A in 2010. Under section 877A, U.S. persons who expatriate are deemed to have sold all of their assets (with some exceptions) at fair market value as of the day before expatriation. Because the grantor trust rules would directly attribute ownership of WCF’s assets to Gunter on such day, the IRS would argue the estate remains liable for the increased exit tax under section 877A.
By comparison, the tax consequences to Gunter (and, therefore the estate) would be remarkably different if WCF were characterized as a foreign non-grantor trust. Specifically, Gunter would have been responsible for reporting and paying taxes only when WCF made taxable distributions to him. Moreover, Gunter would not have had Form 3520-A filing obligations and would have only had Form 3520 filing requirements to the extent that he received distributions from WCF prior to expatriation. Finally, WCF’s treatment as a foreign non-grantor trust would have resulted in Gunter not having to include the fair market value of WCF’s assets in the exit tax computation under section 877A.
Summary
As shown in Geiger, the proper characterization of foreign trusts for federal income tax purposes can be complex. Given the stakes that may be involved, taxpayers should be mindful in ensuring that they are properly reporting their activities from foreign trusts on their U.S. income tax returns. Taxpayers should also be careful in complying with any applicable information return requirements (e.g., Forms 3520 and 3520-A). As Geiger demonstrates, missteps may be penalized.
